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Taxation of Out-of-State Muni Bonds

If you are familiar with investing in muni-bonds then you are aware that they are attractive because they are exempt from federal taxation. This preferential treatment allows local governments to obtain funding for projects at a reduced cost. The concept is to encourage people to invest in things that aid our society.

In additionl to being exempt from federal income taxes, all states that have state income taxes exempt from taxation the income derived from muni-bonds of governments within the state. This further promotes investors to invest within the state. Essentially the state is encouraging investments that help the citizens of the state. (Income derived from muni-bonds issued by governments outside the state is taxed.)

There was the potential of a change on this. The details are below, but this case did reach the US Supreme Court and that court ruled to leave the situation as it has been for a very long time. The remainder of this article is left for historical purposes.

In January 2006 the Kentucky Court of Appeals ruled that the practice of taxing income derived from muni-bonds issued from outside the state (of Kentucky) was unconstitutional. In August 2006 the Kentucky Supreme Court denied review of the case (Davis vs. Department of Revenue; Case No. 2004-CA-001940-MR).

The Kentucky Department of Revenue appealed to the US Supreme Court.

The rules did not change. In such cases it is (or was) prudent to file a state amended return requesting a refund where taxes were paid on out-of-state muni-bonds. The request will be denied, but the point is to open the issue before the statute of limitations closes the return. A tax professional can assist with this.

For California, see the FTB instructions for filing these claims.

"Tax software is no substitute for tax knowledge."

Any views expressed herein are based on our best information. The content of this web site was written as general information without specific individual information and thus may not apply in all situations. This material was not written, and cannot be used by the taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.

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Janelle Ogg, EA
Richard Ogg, EA